Canadian Recognition of U.S. Bankruptcy Proceedings: Not Always a Rubber Stamp for First-Day Orders

First-day orders in U.S. chapter 11 proceedings deal with a wide range of pressing issues within a limited timeframe. Moreover, foreign recognition of first-day orders in cross-border insolvencies, particularly in Canada-U.S. ones, have been dealt with in a context of a high degree of mutual deference and collaboration between jurisdictions. These factors might have led practitioners to assume that recognition of first-day orders by Canadian courts was a given. But recently, in the Payless ShoeSource cross-border insolvency, a Canadian bankruptcy court issued a ruling refusing to recognize a debtor-in-possession (DIP) order issued by a U.S. bankruptcy court. The Payless decision[1] serves as a good reminder that seeking recognition of first-day orders is not automatic and may have a material impact on the restructuring as a whole when all the criteria are not addressed to the satisfaction of the foreign tribunal.

Factual Background

On April 4, 2017, Payless Holdings LLC and 25 related entities (collectively, “Payless U.S.”), along with two Canadian subsidiaries and a Canadian limited partnership (collectively, “Payless Canada” and, together with Payless U.S., “Payless”), filed voluntary petitions for relief pursuant to chapter 11 of the Bankruptcy Code. Payless filed first-day motions seeking entry of various first-day orders, including an interim DIP order for the purpose of financing Payless U.S., which was to be secured by a charge over the assets of Payless Canada (the “DIP order” and the “DIP charge”). A charge such as the DIP charge in Canadian insolvency proceedings is akin to a superpriority lien in the U.S. for the purpose of securing the repayment of interim financing.

Payless operates in multiple countries but is essentially managed out of its head office in Topeka, Kan. Payless also operates on an integrated basis, and for the year 2016, Payless Canada’s sales accounted for 7% of Payless’ revenues, whereas Payless U.S. accounted for about 75% of those revenues.[2] It is well accepted that Payless Canada, although itself solvent, is entirely reliant on Payless U.S. for its operations.[3]

Payless’s chapter 11 proceedings were then meant to be a pre-arranged restructuring with the aim of allowing Payless to continue as a going concern, through a comprehensive financing restructuring and recapitalized plan to be implemented through the chapter 11 proceedings. The DIP order and DIP charge were part of that plan. As such, Payless U.S., along with Payless Canada, immediately applied before the Ontario Superior Court of Justice (Canada), acting as Canadian bankruptcy court in the matter (the “Canadian Court”), seeking recognition orders under the Companies’ Creditors Arrangement Act[4] (CCAA) — i.e., the Canadian equivalent of chapters 11 and 15.

The Canadian court proceeded to recognize without any difficulty the chapter 11 proceedings as “foreign main proceedings,” with Payless’s center of its main interest being in the U.S. However, the Canadian court refused, in its decision released on April 20, 2017, to recognize the DIP order and to issue the DIP charge.[5] It did so despite recognizing that the CCAA provides that the court shall cooperate, to the maximum extent possible, with the foreign court involved in the foreign proceedings, and notwithstanding the fact that in the context of cross-border insolvencies, Canadian courts have consistently encouraged comity and cooperation among courts in order to enable enterprises to restructure on a cross-border basis.[6]

Canadian Court’s Refusal to Recognize the DIP Order and to Issue the DIP Charge

The Canadian court did not decline to recognize the DIP order lightly.[7] It phrased the issue before it as follows: The DIP agreement requires Payless Canada to be guarantors and to employ their assets as collateral for the indebtedness under the DIP, even though Payless Canada is not a borrower, will not receive any advance under the DIP and holds unencumbered assets.[8] Payless alleged that without this financing, it would be unable to finance its operations. This, in return, would have a disastrous effect on Payless Canada, which cannot survive without Payless U.S.[9]

A group of Payless Canada’s landlords opposed foreign recognition of the DIP order and the DIP charge. As of the filing of the chapter 11 proceedings, the landlords had no claim and were only contingent unsecured creditors, their exposure being only that Payless’s intention to continuing operations and to pay the rents going forward could change depending on economic conditions. The landlords could incur a loss for any damages resulting from unpaid post-filing rents and the potential termination of leases. The landlords argued that the DIP order and the DIP charge gave them no adequate protection and otherwise provided no benefit to a solvent Payless Canada. They also argued that the other main unsecured creditor groups were being granted protection through superpriority liens on Payless Canada’s assets, and as such, other unsecured creditors were receiving more favorable treatment than the landlords. As Payless Canada was solvent, they argued that arrangements had to be made so that they could be no worse off if the Recognition Order was granted. The landlords also argued that the DIP order should provide that the DIP lender would look first to Payless U.S.’s assets in case of realization.[10]

The evidence for the material impact of the recognition of the DIP order was clearly put forward before the Canadian court, which did consider it. Notably, it was argued that Payless U.S. needed all the liquidity provided by the DIP, for which the DIP lenders required recognition by the Canadian court within five days of the issuance of the first-day orders. Payless did reiterate that the viability of Payless Canada depended on the viability of Payless as a whole, underlining the rationale for Payless Canada’s creditors, which would otherwise be unaffected, to share the burden and risks of this restructuring.

However, the Canadian court ruled that the fact remained that prior to the chapter 11 filing, Payless Canada was not a borrower, and that providing security for the DIP without a proper mechanism to protect the position of the landlords, contrary to the other creditors of Payless Canada, was detrimental to their position and justified the refusal to recognize the DIP order.

Lessons to Learn

The structure of the restructuring contemplated by Payless with respect to the financing of the insolvent crown jewel of its business with the estate of foreign solvent but dependent debtors was nothing that unusual, and was not inherently unfair or prejudicial. It had been done before, with a strong rationale similar to the one in Payless, which was that although solvent, the foreign-related debtor was entirely dependent on its parent group of companies and existed because of them.[11]

However, considering the potential impact it could have on Payless Canada’s stakeholders, there were important considerations that needed to be addressed for it to be acceptable in the eyes of the Canadian court, such as the sufficient protection and fair treatment of the landlords in relation to the other creditors. The Canadian court declined to recognize the DIP order despite its importance for the overall restructuring, mainly because it could not find an acceptable justification for the unequal treatment of the creditors impacted. This issue had not been fully addressed in the first-day orders.

In that sense, the Payless decision may serve as a good reminder that first-day orders are issued in an expeditious way, and understandably so, but that when foreign recognition of such orders is sought, it is not always a given if all criteria are not properly met. The urgency and importance alleged of the first-day orders submitted for recognition will not invariably remedy the shortcomings. This lesson applies even more so when an important part of the overall restructuring contemplated rests on the recognition of said first-day orders, as was the case in Payless.

This article was originally published in the August 2017 edition of the Young and New Members Committee Newsletter. Participation in ABI's committees is one of the many benefits of becoming a member. Committees provide networking and leadership opportunities. For additional information on how you could become involved in ABI and our Committees please visit membership.abi.org.

[1]Payless Holdings LLC (Re), [2017] 2017 ONSC 2321 (Can. Ont. S.J.). On April 7, 2017, an Initial Recognition Order was granted in these proceedings, and the reasons reported at Payless Holdings LLC (Re), [2017] 2017 ONSC 2242 (Can. Ont. S.J.), should be read in conjunction with these reasons.